Petco Health & Wellness Company, Inc. Q3 FY2024 Earnings Call

Good afternoon, and welcome to the Petco Third Quarter 2024 Earnings Conference Call. Please note that this event is being recorded. I would now like to turn the conference over to Lisa Stark, Senior Director of Communications. Please proceed.

Good afternoon, and thank you for joining Petco's Third Quarter 2024 Earnings Conference Call. In addition to the earnings release, there is a presentation available to download on our website at ir.petco.com, summarizing our results. On the call with me today are Joel Anderson, Petco's Chief Executive Officer; and Brian LaRose, Petco's Chief Financial Officer. Before they begin, I'd like to remind everyone that on this call, we will make certain forward-looking statements which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation, and SEC filings. And finally, during the Q&A portion of today's call, we ask that you please keep to one question and one follow-up. With that, let me turn it over to Joel.

Thank you, Lisa. Good afternoon, everyone, and thank you for joining us today. Our third quarter results came in slightly ahead of our expectations as we more effectively navigated a dynamic consumer environment and the actions we are taking to strengthen our retail fundamentals and drive cost out are beginning to take hold. Revenue was $1.51 billion, up 1%, driven by consumables and services. Gross margin expanded 130 basis points to 38.1% and was driven by progress on product cost management and improvements in services margin. Adjusted EBITDA was $81.2 million. While there is much more work to do, our improving results increase our conviction that we are on the right path as we position Petco to win. Throughout the quarter, I spent a significant amount of time meeting with teammates across the organization. I'm working alongside our associates at our pet care centers, visiting our distribution centers, and hosting small group listening sessions at our support centers. I've witnessed firsthand the passion our people have for pets and the dedication they bring to serving our customers. Importantly, it's exciting to see the entire organization rally behind our plans to drive operational and financial performance improvement. On our last call, I outlined our commitment to resetting the trajectory of our business. Today, I will share specific areas of opportunity, discuss developing plans to drive improvement, and hold ourselves accountable while we're on the path to returning to long-term sustainable profitable growth. Our initiatives are currently focused on three critical areas: merchandising, servicing our customers, and driving efficiency across our business. Allow me to provide you with an update on each, including specific examples. First, improving merchandise remains the greatest near-term opportunity for us to strengthen profitability. I'd like to take this moment to thank our merchandising team along with our merchant vendor partners for their collaboration and support as we take the necessary steps to make Petco a better retailer, employer, and partner. We're optimizing our assortment to align more closely with customer demand and make it easier for them to shop with us. In support of this, we completed a detailed review of our assortment across both consumables and supplies and have identified several opportunities to enhance our offering. Key focus areas for us include creating more space on shelves for faster-turning SKUs as well as reducing SKUs in certain categories to simplify the customer's decision-making process. In addition, I've met one-on-one with several of our vendors to learn how we can improve our relationships. As consumers continue to be judicious in their spending, we have to meet them where and when they want with the value they're looking for. We've implemented new processes to deliver timely product resets that allow us to offer more exciting products. We're also sharpening our approach to pricing to remain competitive in the market and drive financial outcomes for Petco. To date, we've put in place stronger pricing guardrails, implemented more robust reviews of our pricing gaps, and established processes for promotional assessments. An example of our merchandising work in action is the recent launch of our Welcome to the Family Program, given the importance of first-time pet ownership. We designed this program in partnership with our key vendors, as well as our expert vet, training, and grooming teams to provide dog and cat parents with guidance, resources, and savings on new pet essentials and services. Second, to win in today's retail environment, we must improve the way we service our customers across our pet care centers, online, and in our services platforms. From my time spent working in our pet care centers, I observed several opportunities to drive greater consistency across the entire footprint, which will generate savings that can be reinvested into the customer experience and strengthen profitability. Let me share several examples of where we are making meaningful improvements to better serve our customers. We've set new standards for our labor model to staff our stores in a way that allows our partners to spend more time with customers and less time on tasks in the back of the store. This extends to store leadership, where we're reducing tasking, administrative responsibilities, and overall complexity for our general managers, empowering them to spend more time leading their teams and driving store productivity. Additionally, leveraging automation to standardize the online order fulfillment process in our pet care centers is one area in particular where I see significant potential. Finally, in services, our veterinary offering remains a key growth driver and differentiator for Petco. Services revenue was up 9%, with strength across both hospitals and Vetco mobile clinics. As our hospital fleet continues to mature, our services team is focused on accelerating utilization to support structural margin improvement of our veterinary hospitals and ensure we can meet the growing demand for our customers in a timely manner. We're leveraging our vet customer data to better understand their purchasing patterns, inform how we engage with them, and ultimately drive greater wallet share. These initiatives are having a direct impact on our top and bottom line as we're creating more selling opportunities for partners while simultaneously driving greater efficiencies. Turning to our third commitment, driving greater efficiencies across the business to reduce costs. Within merchandising, we're taking action to improve our commercial execution. In Q3, we completed key vendor negotiations and we're pleased with the outcome as we continue to strengthen our vendor relationships and differentiated merchandising offerings. In our supply chain, we are renegotiating multiyear contracts with our shipping partners, reducing split shipments, and driving incremental improvements in distribution center labor to reduce costs per shipment and improve speed of shipping. We are closely measuring performance at the individual hospital level, providing us greater visibility into the needs of each hospital and the staffing required to maximize efficiency and productivity. We believe there is significant opportunity to improve the profitability of the existing fleet by ensuring hospitals remain staffed and are supported through marketing and merchandising efforts. We're also taking action to professionalize our procurement team. As a start, we requested contract negotiations and conducted RFPs across a broad selection of medium to large-scale indirect procurement partners. We're pleased with the engagement and the outcomes we're seeing so far. Overall, our cost initiatives are well underway and tracking against our prior expectations. Importantly, these aren't just one-time savings. These initiatives are designed to fundamentally change the way we think and work to consistently identify areas of opportunity to unlock long-term value. This redefinition of retail fundamentals is expected to have an enduring impact on our people and culture, leading to greater accountability and transparency. To further ensure our success around our three initiatives of merchandising, servicing our customers, and driving efficiency, we've added two key executives. Leadership is critical to shaping the direction of the business, and I'm pleased with our recent hiring of two new leaders that will help us realize our full potential. We named Joe Venezia Chief Revenue Officer, a newly created role in charge of developing the integrated strategies for improving the customer experience and driving revenue across the organization. Joe will oversee these critical areas that contribute to Petco's growth, including the pet care centers, services, real estate, and customer success capabilities. Dan Calista also has joined us as our Chief Strategy and Transformation Officer. In this role, Dan will be responsible for building the internal capabilities we need to get our fundamentals right, maintaining accountability through our ongoing transformation, and positioning ourselves for growth. These hires underscore our top priority for improving profitability through structural cost reductions while positioning Petco for growth. It's still early days, but our actions are beginning to take hold, and we're setting ourselves up to play offense as we build momentum into fiscal 2025. Before I close, let me leave you with this: Having been in the role for over 100 days, I can say with conviction and certainty that I am more excited today than I have ever been about our potential here at Petco. The time I spent working alongside our associates showed me how their knowledge, expertise, and raw passion for improving the lives of pets and their parents is unmatched in the industry. This enthusiasm that sets us apart makes me confident in our trajectory. With that, over to Brian to provide more details on our financial performance and guidance.

Thanks, Joel, and good afternoon, everyone. First, I want to extend my thanks to our Petco partners for their continued dedication to delivering for our customers. Our third quarter performance demonstrates improved operational and financial execution enabling us to deliver results ahead of our expectations. For the quarter, net revenue was $1.51 billion, up 1% year-over-year, with comparable sales up 2% year-over-year. Breaking this down by category, consumables grew 3%. Supplies in companion animals remained soft at down 3%, but improved roughly 200 basis points sequentially on a percentage basis. Services and Other, which is comprised of services, wholesale, and recently disposed non-core businesses delivered 5% growth. Services specifically were up 9%, driven by ongoing strength in our vet hospitals, mobile clinics, and grooming. Moving down the P&L, gross profit was $576 million, up 5% from prior year. Gross margin for the quarter was 38.1%, up nearly 130 basis points from the prior year, driven by progress on product cost management and improvements in services gross margin. SG&A was $572 million, increasing 2% year-over-year. As a percentage of sales, SG&A rate was 37.8%, up nearly 40 basis points, driven primarily by our planned step-up in store labor in line with our expectations and reflecting our commitment to improving the in-store customer experience. We expect these increased SG&A costs to continue into the fourth quarter. Adjusted EBITDA was $81.2 million with an adjusted EBITDA margin rate of 5.4%, up almost 60 basis points year-over-year. All in, adjusted EPS was negative $0.02 compared to negative $0.05 per share in the prior year. Turning to the balance sheet, merchandise inventories were $690 million at the end of the third quarter as we effectively controlled our inventory, which, along with stock rates, are in excellent shape. Liquidity remains strong at $644 million, inclusive of $117 million in cash and cash equivalents and $528 million of availability on our revolving credit facility. CapEx was down $31 million year-over-year for the quarter. Year-to-date, it's down approximately $85 million year-over-year, in line with our guidance to reduce CapEx in 2024. Free cash flow was negative $10 million, a meaningful improvement year-over-year supported by lower inventory levels achieved as part of our ongoing approach through disciplined inventory management. We remain firmly on track to deliver positive free cash flow for fiscal 2024. Before moving on to guidance, let me address the recent announcement of potential tariffs on goods imported from China, Mexico, and Canada. We have a few immaterial vendors from whom we source directly from Mexico and Canada, which we do not expect to impact us negatively. Regarding China, relative to broader retail, we have a lower level of exposure to imported products, and we believe the proposals as currently outlined would not be meaningful to our overall business. Specific to Petco Mexico, we do not source or import any products from them. Rather, they source their products primarily from the U.S. with select products exported directly to them from Asia or sourced directly from suppliers based in Mexico. Petco Mexico remains the clear market leader in pet specialty in Mexico and an important strategic partner for us, continuing to drive long-term profitable growth. I'll now turn to outlook. As a reminder, Petco's fiscal 2023 fourth quarter and full year included an additional week. For the fourth quarter of fiscal 2024, we expect revenue of approximately $1.55 billion, adjusted EBITDA between $90 million to $95 million, which is inclusive of a minimum of $10 million in third-party consulting fees associated with our transformation effort and adjusted EPS between $0.00 and $0.02. Additionally, for the full year, we expect net interest expense of approximately $140 million, inclusive of the estimated impacts of our hedges against the forward rate curve, 273 million weighted average fully diluted shares, and $130 million of capital expenditures. Stepping back, we're encouraged by the structural improvement we're seeing throughout the business. The meaningful changes we've made in the first nine months of the year sets us up for a solid finish to 2024 as we build momentum heading into 2025. Thank you for your time. And with that, we'll be happy to take your questions.

The first question comes from Kaumil Gajrawala with Jefferies. Please go ahead.

Thank you. I guess the first question, you've made a lot of progress on the cost side. What would be a target same-store sales figure where you can start leveraging off this newer cost base?

Thank you for the question. I'll give you some of my thoughts and Brian, if you want to add anything. Look, I think our focus right now is, as you said, even in your question, is about taking costs out of our base permanently. It's a structural change that we want to embed in our DNA to drive accountability and transparency. But as it relates to the longer term in the question you're asking, I think that's something that we should leave for March as we think about the longer term. A lot is going to change. Obviously, the number is much lower right now because we're so focused on structural elements of costs that we think are permanent and not one-time.

Yes. I would just add to that. If you look at SG&A, we've talked for two, three quarters in a row now about sort of step-up in labor investments that we needed to make to improve the in-store customer experience. We've done that. We've seen that actually manifest in an improved customer experience in the stores. Simultaneously, we have taken costs out of the SG&A structure, through some G&A actions as well as making sure that we reduce the tasks in store, simplifying the experience for our GMs and partners in the store and again, improving that customer experience.

The next question comes from Steve Shemesh with RBC Capital. Please go ahead.

Great. Good evening, and thank you for taking my question. I would like to ask about supplies and companion animals in the more discretionary segment. It's still negative, but the underlying trend is improving. Can you elaborate on whether this improvement is across all subsegments or if there are specific subsegments that provide additional insights?

Yes. Look, I think you're asking about discretionary. I think it's more important that you think about Petco in the broader business, which as I look at it, is really two-pronged. We have a huge consumables business, and that's really all about being in stock. And that's where a large focus of ours has been. We just implemented a new inventory management system. We're improving shelf utilization. And then as it relates to discretionary, you're right, we've seen a 200-basis point sequential improvement. But discretionary is really all about innovation, newness, being trend right, and really driving impulse buying. We'll continue to get better at that, but we're really focused on both sides of the business and getting them right.

Got it. Helpful. Thank you, and maybe just as a follow-up. One of your competitors has been talking for a few quarters now about adoption trending in the right direction. Curious if that aligns with what you guys are seeing in the market. I know the data for adoption is pretty spotty. And if not, has it stabilized? What are you looking for to maybe get ahead of an inflection there?

Yes. Look, I think everybody is looking at it a little bit differently. The market is rather flat is what we're seeing. But as it relates to Petco, in the short term, and by that, I mean, throughout 2025, we're really in a self-help situation in that we don't have to rely on the market getting better in order for our business to get better. And so, look, if the market improves, like you're talking about, that's just icing on the cake and makes us even stronger. We're really focused on what's in our control, and we don't need the industry success to drive near-term operational and profit improvement, the market growth upside, as I said.

Thanks. Got it.

And the next question comes from Seth Basham with Wedbush Securities. Please go ahead.

Just wondering if you could talk about the pricing impact in the quarter, whether it was positive or negative and how we should think about pricing going forward as you tweak your product mix?

Yes. Thanks for the question, Matt. We don't typically talk about the impact of pricing. I will tell you that the overall environment has been rational, both from a pricing standpoint and a promotional environment.

Great. I was just wondering then if you could talk about the services margin and what drove the improvement there this quarter?

Yes, a couple of things. First, I'll talk about overall gross margin. If you look at our gross margin improvement year-over-year of 130 basis points, that was with mix going against us. So, although supplies and companion animals was down 3% versus 5% last quarter, it was still a negative mix year-over-year. The two biggest drivers of the gross margin improvement for the company were, number one, our cost actions taking hold and seeing improvement throughout the cost ecosystem. Number two was that services gross margin improvement that you talked about, and that's a function of a number of things. First and foremost, it would be the maturation of the veterinary hospitals and all the great work that the team is doing there on a hospital-by-hospital basis. As Joel indicated, we believe we have ample opportunity to improve the profitability of the existing vet fleet. Second would be the continuation of strength in our Vetco Mobile business. Vetco Mobile is a volume and utilization business, and we continue to actually increase the top line in that business. With that comes incremental margin improvement. The grooming business also remains strong for us.

The next question comes from Michael Lasser with UBS. Please go ahead.

Thank you so much for taking my question. So, Joel, it seems like your initial priority is to come in, cut costs, and focus on retail fundamentals. So, a, how much of an opportunity for savings is there? If you could size that, that would be great. And b, how much of that are you going to have to reinvest in the business to drive sustainable same-store sales growth because as we know, this is a very competitive market with some reinvigorated players who are all looking to address the addressable market here. Thank you.

Thanks, Michael, and good to hear your voice. Look, I think at the phase we're at right now, Michael, none of what we're taking out at this point in time is stuff that we see we need to reinvest. We think we still have significant more cost-out opportunities and as we get down to that second wave of stuff, certainly, that's when we'll start to look at things to reinvest like more marketing to drive top line growth. But at this point in time, our real focus right now is about taking costs out of the business. It's not just one-time in nature, that has to be reinvested in the business, but it's a permanent cost out. And that's kind of how we're thinking about it, Michael.

And the next question comes from Steven Zaccone with Citi. Please go ahead.

Thank you for taking my questions. My first question is how has the business trended thus far in 4Q? And are there any call-outs for holiday performance relative to the implied 4Q outlook for revenue growth?

Look, I'm not going to get into inter-quarter trends and stuff. I mean that's clearly reflected in our guide. We're pleased with the start of the quarter, and you can see by the guide, the sequential improvement from Q3 is a nice improvement. And so that's kind of where we're tracking for now. And I think we've got momentum going into the back half of the quarter here.

And then my follow-up is, how do you think about the ability to regain market share in 2025 and in the medium term? Aside from better growth in the category, what do you see as the specific drivers to have customers reengage with Petco?

Hopefully, what you gathered from my remarks is that I feel more optimistic than ever about my decision to join Petco. The enthusiasm I observed from our associates and the collective effort to turn this business around and return to retail best practices definitely positions us for growth in 2025 and beyond. As for specific numbers, we will share those with you in March next year, but I hope my tone in my prepared remarks conveys my excitement about the progress we've made in a remarkably short time.

And the next question comes from Steve Forbes with Guggenheim. Please go ahead.

I wanted to touch on the hospitals and opportunities for efficiency enhancements. I think you mentioned a need for full-time staffing, maybe some improvement on the merchandising side. So, any color you can provide on staffing and merchandising and maybe the anticipated lift. And then finally, any way to contextualize the margin for the vet clinics and maybe the scaling to get there. Thank you.

Yes. If I heard you right, your question was about the hospitals. Look, we've made a lot of progress this year. Stephen, who joined us earlier this year and leads our hospital operations team has just done a great job of delivering better profitability, helping us invest better in terms of staffing, utilization rates, and so on. So, the progress we're making there is fantastic, and it certainly resulted in sales continuing to grow. I mean our hospitals in Vetco were up 17% this last quarter, and I'm really pleased with the progress we're making with hospitals and vets overall. Is there a second part to that question I missed?

Maybe on the merchandising opportunities there and just how you guys are thinking about the end state margin for the vet hospital business and maybe the scaling to get there? Is it more like an intermediate think longer-term...?

I believe that in terms of merchandising, we are improving our prescriptions and enhancing the connection between our vets, stores, grooming, and product recommendations. This is still an area where we are in the early stages and have room for improvement. Regarding our margin goals, there's a significant amount of potential left to explore, and we haven't reached our maximum margins yet. Our hospitals are also developing, and we will keep making progress as our utilization rates increase.

And the next question comes from Zach Fadem with Wells Fargo. Please go ahead.

Thank you for taking my questions. So, I guess how should we think about the potential glide path of gross margin improvement from here? And is there any color you can provide around Q4 outside of lapping the 130-basis point inventory write-down?

Thank you for your question. We won't provide guidance on gross margin for the remainder of the year. However, we are encouraged by our Q3 results. There were two primary factors contributing to the year-over-year improvement. The first was the positive impact of our cost actions, and the second was the enhancement in our services business, even though the mix was not in our favor. We are beginning to see these actions take effect. Joel mentioned that these changes are not just one-time events but are fundamental to our operations and company structure. Beyond this, we are not offering any forward-looking insights.

Can you talk about the 3% decline in services in companion animals in the context of the broader market?

I would contextualize it this way. Just as we said earlier, we're in self-help mode here. And when we think about the market, we are not passively waiting for the market to recover in supplies in companion animals. We're taking actions, and part of the cost actions are in those two categories. The assortment actions are in those two categories. And we see a lot of room for improvement for us regardless of how the market performs overall.

The next question comes from Simeon Gutman with Morgan Stanley. Please go ahead.

I wanted to ask about the consumables improvement in Q3. Just curious to know if this was ticket-driven. Are you seeing new pet owners coming? Just any color on the improvement there? Thank you.

Yes. Look, consumables were something I talked about a couple of questions ago. This business is all about being in stock. I think it's a combination of our new inventory management system that's now fully in place in Q3. It's about the team getting better at flowing inventory, better shelf utilization, and being priced competitively. So, all those actions we're taking are starting to show up in better sales, and that's what you saw start to happen in Q3.

I would just add one thing to that, and that's not fresh frozen continues to be really strong for us. That was up 20% year-over-year in the quarter. So that continues to be strong.

And the next question comes from Kendall Toscano with Bank of America. Please go ahead.

Thank you for addressing my question. I wanted to revisit the opportunities you mentioned in merchandising and improving the terms with your suppliers. It might still be early, but I'm interested in any updates regarding the response from vendors and their openness to your initiatives.

Yes. Thanks for the question, Kendall. Look, I actually think I commented specifically in my prepared remarks. The discussions with our vendors have been really well received. I personally have met with some of our merchandising vendor partners myself. The key to all that is transparency and openness and talking to them about what they need as much as what we need. We've had really successful discussions as we build our joint business plans for 2025, and I'm really pleased with the progress our merchant teams have made.

Got it. Another question I had was about the vet hospitals and if there's any update on when you plan to start rolling those out again, since you're optimistic for this year and the foreseeable future. I'm curious about the timeline for that.

Yes. The vet hospitals are a key growth driver for us. They are also a key differentiator for us as all our vet hospitals are Petco-owned. As far as what the specific growth for next year will be, we'll lay that out for you in detail as we get into March, but we do expect that to continue to be a growth driver for us.

And I would just add, Kendall, the decision to open a handful this year was not because that's not strategic, or not because we don't believe it's a short, medium, and long-term opportunity. It was made because we wanted to make sure we continue to strengthen our balance sheet, generate free cash flow, and get the company back in a position of strength so that we can invest in those high ROI projects moving forward.

This concludes our question-and-answer session. I would like to turn the conference back over to Lisa Stark for any closing remarks.

Thank you for your time and for your questions. That concludes today's earnings call. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.